What is the difference between Effective and Marginal Tax Rates?

Taxes can be complicated and the rules change quickly. It’s important for people to understand the basics so they can maximize savings and also avoid underpayment. Two important pillars of income taxes are the effective and marginal tax rates. Both rates determine how much taxes an individual owes but do so in different ways.

Effective Tax Rate

The effective tax rate is the average tax rate a person or organization pays. It is represented as a percentage and represents the share of income that is used to pay Federal taxes. Calculating the effective tax rate can be a more accurate way of knowing what your tax bill is than relying on your tax bracket.

To calculate the effective tax rate, you divide your total taxes by your taxable income.

The effective tax rate is usually lower than the marginal because your income is taxed at lower rates first before laddering up to a higher rate. As you’ll learn later on, marginal tax rates are based on your highest tax rate.

Example of Effective Tax Rate

The equation for the effective tax tax rate is:

Total tax expenses/taxable income

Using a real-life scenario, if someone had taxable income of $90,000 (after subtracting deductions and exemptions) and their tax bill was $16,290, then their marginal tax rate would be roughly 18%.

That’s $16,290/$90,000= effective tax rate.

Marginal Tax Rate

Marginal tax rate is an individual’s tax rate based on their income tax bracket. There are seven marginal tax rates and they range from 10% to 37% in 2023 and 2024. Within each marginal tax rate, there is an income tax bracket or income threshold. A misconception people often have about marginal tax rates is that it applies to all of their income. This isn’t the case as the U.S. follows a progressive income tax method. This means as an individual’s income increases, so does their tax bill, but only the income that falls into a higher tax bracket is taxed at a higher rate.

The IRS reviews the income tax brackets every year during their annual inflation adjustments. The objective of the review is to ensure tax brackets keep pace with inflation. For instance, in 2022, a year when inflation was high, the IRS passed a historic tax bracket increase, raising each bracket by 7% .

Example of Marginal Tax Rate

If someone earned $90,000 in 2023, they would fall into the 22% tax bracket, but they wouldn’t be paying 22% taxes on their entire income. They would pay 10% on the first $11,000 assuming they’re a single filer, 12% on their income between $11,001 to $44,725 and then 22% on the income between $44,726 and $95,375.

10% of $11,000 = $1,100
12% of the next $33,724 of income ($44,725 – $11,001) = $4,046.88
22% on $50,649 of income ($95,375 -$44,725) = $11,142.78

In this example, the highest marginal tax rate would be 22% and the total taxes owed would be $16,290 rounded.

Note that while the marginal tax rate in this example is 22%, the effective tax rate mentioned above is 18%, which is lower. Either way, people can lower their tax bill by utilizing tax deductions, which can lower your tax rates and tax credits, which lower your tax bill dollar for dollar.

Taxes can be complicated, which is why many seek the help of tax advisors come tax season. If you’re unsure of how to calculate your taxes and make the most of deductions, reach out to a professional.